The following definitions and descriptions help explain the commodities trading industry and some of the misconceptions that exist regarding it. A more complete list of definitions is included as an appendix herein.
MARKETS:
Cash (physicals): Refers to the physical exchange of commodities, either directly with importers, exporters, and processors or between two intermediaries. Jane is a cash trader.
Paper: A regulated exchange to trade futures and options contracts. Futures represent a specific quality, quantity, and standard delivery and performance terms. Options are contracts which offer the right to buy or sell the underlying futures contract. Paper traders take ownership of the physical product, but will always liquidate their position in contract before it expires, thereby avoiding taking possession of the underlying commodity. Dick is a paper trader.
KEY TERMS:
FOB (Free on Board): Seller relinquishes title to goods at origin once it crosses the rail of the loading vessel.
CNF (Cost and Freight): Seller transfers title to the buyer at the destination port.
CIF (Cost, Insurance & Freight): Seller pays for all shipping costs and cargo insurance.
Liquidity: Volume of bids and offers in both cash and futures markets. Higher liquidity yields more trading opportunity and less risk associated with completing (or reversing) a position—Critical for traders without the ability to store and ship the physical commodity.
Transparency: The amount of information readily available to accurately reflect current market prices.
Clearing: Intermediary's performance guarantee to buyer and seller. The intermediary is responsible for all replacement costs if either counterpart defaults.
Clearinghouse: Guarantor of customers' performance, daily reconciliation of each futures and options contract traded on behalf of clients, and net affect on subsequent margin positions (percentage gain or loss versus settlement price required as deposit.
CASH MARKETS PLAYERS:
The trade: International conglomerates who intermediate between commodity exporters and importers. The brochure for the trade house Jane works states that they facilitate the flow of worldwide commodities by assuming and managing distribution risks. It's not that glamorous.
Cash Broker: Matches buyers and sellers of physical commodities. A cash broker does not take title to the goods and often acts as an over-the-counter futures broker as well. Mostly focuses on the active second-hand market between trade houses, who juggle “inventory” around the globe, trying to purchase and deliver the cargo from the least expensive source.
PAPER MARKETS PLAYERS:
Locals: A clearing member (or its employee) of the futures exchange who executes customer orders (open-outcry market) and usually trade for their own account.
Paper traders: Institutions, individuals and hedge fund managers who seek profits by trading futures with no intention of holding contracts until expiration, thereby avoiding the physical receipt or delivery of the physical product. Many are on Wall Street, but Dick works in Midtown.
Many people assume that the physicals (“cash”) are to futures markets (“paper”) what stock brokers are to NYSE, yet futures were created to hedge the delivery price of commodities in which they anticipated buying or selling at a future date (the end of the harvest). Although investment activity comprises the majority of futures volume today, exchange traded contracts are the root of all world market prices and still the primary source of price protection for world trade participants. The following scenario help differentiate between the two and describes a particular situation that can benefit from the present invention.
Jane is a cash trader; Dick is a paper trader. Jane buys sugar from the farmer today at a fixed price. Since she won't receive it until later, she sells futures for the same quantity to guarantee a minimum price. Dick sold futures to Jane and others since he thinks prices are going down.
Commodity trading is risky—for dick and jane—users of the present inventive systems and methods. These systems and methods can, but do not necessarily, provide clearing services as the custom of the trade does not require such for cash transactions.
One day, Jane buys a cargo of Brazilian sugar with no particular destination in mind. She immediately sells futures for price protection (hedging) even though she's feeling lucky and bullish.
Jane is very happy. Only a week after buying the sugar, she sells it with a big, fat premium. She liquidates her hedge and loses money buying the futures back, but still has the big, fat, premium leftover. If she had been wrong about the market, she would have held the futures until expiry and delivered the sugar to a buyer on the exchange. In this worse case scenario, she limits her losses to the cash premium she paid to the Brazilian mill.
Jane loves her job, especially when she's right. Dick thinks it's a silly waste of time. He couldn't be bothered to charter a vessel, worry whether the boat would sink or if the customer on the other half of the globe decides not to pay. Instead, he just takes twice as much of his bank's money, sits in front of a screen with two phones and his charts, and makes just as much profit as Jane.
In paper trading, the trader must formulate and implement strategies in futures and options markets to compliment hedging and management of physical positions. This involves short and long term analysis of fundamental, technical, political and economic factors. To perform the risk management and operations responsibilities, position limits, margins, profitability, risk/reward of physicals and futures options, counter party risk, country risk, all must be monitored. While in cash trading, the trader must tailor short and log term contracts to meet price risk, payment and scheduling concerns of the counter party within a trade house's profitability objectives. This requires intensive travel to maintain an in-depth knowledge of customers, political and cultural climates, vertical growth opportunities, and risk management issues.
In the past, on-line or electronic exchanges have been developed for specific environments. However, these exchanges are limited to the interaction and involvement between two parties and in may cases have been nothing more than matching software to determine the coincidence of different bids and offers. Until now, such exchanges have not provided a comprehensive marketplace open to multiple types of parties, each having different needs and purposes for being there, nor have they provided an aggregation of services, software, participants and information necessary to change the way trading is performed.
One area in commodities that has seen some experimentation into on-line exchanges is that of energy. However, in addition to the differences stated above, energy differs from soft commodities and the agri-market for a number of fundamental reasons such as the number, size and influence of market participants, the rigidity of standard contracts, profit margins, volatility and the measure and practice of risk management.